Morningstar Advisor - Spring 2008 - 58

Morningstar Conversation RP: It has. We’ve raised it since we initiated the positions, because we didn’t anticipate the market being as good as it is for the new business they’re writing. Now, what I’m going to say is not a fair statement, but if they marked all of their business to the current margins that are available in the market, and they didn’t lose anything on the historical book, each of these companies would be earning around $10 a share, and each of the stocks are around $20 a share. You never ever see that. KK: What do you think is a more normal earnings level for them? RP: $6 or $7 a share. Obviously, you don’t apply the current good environment, but you also don’t apply the really terrible environment from two years ago when their spreads were very narrow, because everybody else was competing with them to buy these mortgages. If you put it somewhere in the middle, you get around $6 or $7 a share. And that is a conceptual earnings power, because each quarter the accounting requires them to mark to market. So you have to assume that spreads return to normal and stay normal. Then, that’s how they earn that kind of money. KK: What about Citigroup? Has your valuation KK: Is the international franchise more valuable? RP: The whole franchise is intact. You have the credit-card business. Credit card has nothing to do with this. There wasn’t any excess in credit-card issuing in the past five or seven years. A lot of the business is outside the U.S., which is a really valuable franchise, because they tend to be in markets where there’s very limited competition, and they make a lot of money in those markets. In the U.S., there’s only three or four credit-card companies that make any money, because it’s a scale business. That’s about a quarter of their earnings. Then, you have the New York City retail banking network that they make some money off of. That’s not impacted by this. They have Smith Barney, which is a wealth management platform, not impacted by any of this. They have foreign currency trading globally. They have interest-rate swaps. The percentage of their earnings that came from structuring CDOs, which is where they got caught up, was minuscule. It was probably about 5% of their earnings. Assume that’s gone. The beauty of investment banks is that they go to wherever the money is to be made. They never make money the same place they did five years ago. They’re going to be doing work on restructuring and distressed and workout situations. They were doing none of that two years ago. That’ll replace the earnings that they had in selling all these fancy instruments. KK: What would you like the new management at Citi to focus on first? RP: You know, the world acts as if there was something massively broken at Citigroup. The reality is Citigroup suffered for the last couple of years from a slope in the yield curve, which is a case of where even the best management in the world wouldn’t have been able to have a different outcome. They probably need an upgrading of risk controls; they probably have to review their assets. They’ve clearly had blowups in various areas in the past. But structurally, the idea that they should break up the company, to me, seems silly. Maybe in the future, but not when… KK: You don’t want a fire sale. RP: Why would you sell something today? It makes no sense. And if you add up the pieces and value them separately, that wouldn’t be good, either, because nobody likes any of the pieces. KK: You’ve also dipped into the insurance area. What’s your thesis with Allstate ALL? RP: Allstate is a great franchise that went through a cycle improvement over the past four, five years, and its earnings rebounded nicely. Its share price has never really reflected the good market conditions. We’re sitting here earning a very high return. The book value’s growing very nicely, and it’s selling for as low a multiple of book as it ever has sold for. (Allstate closed at $46.71 on March 6.) KK: What are your least favorite stocks today? RP: Anything tied to the whole China story. To the extent that you could get out of China completely, that would be my recommendation. Postscript: A month after this interview, Pzena confirmed that he still very much likes the stocks mentioned in this article, despite their recent rebound. K Kunal Kapoor is president and chief investment officer of Morningstar Investment Services (www.mp. morningstar.com). Kapoor owns shares of FNM and C. changed there much since you bought it? RP: It has; it’s been impaired due to dilution, though not deterioration in earnings power. (Citigroup closed at $21.17 on March 6.) KK: Do you think Citigroup’s earnings were inflated by the housing boom? RP: They weren’t players in the housing market. KK: But clearly they benefited from that one way or the other. RP: A very, very small percentage of their earnings. Citigroup doesn’t derive its earnings from fancy financial structuring transactions. View video excerpts of Pzena and Kapoor’s conversation at: http://MorningstarAdvisor.com/Conversation.asp 58 Morningstar Advisor Spring 2008

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Morningstar Advisor - Spring 2008

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